To prove unreported income, the government could use the net worth method, which is an indirect methods.
The net worth method relies on circumstantial evidence to show increases in net worth that do not match an individual’s reported income.
Net Worth Method Generally
The theory of the net worth method is that if an individual has more wealth at the end of a given year than at the beginning of that year, and the increase is not from non-taxable sources such as a gift, loan, or inheritance, then the amount of the increase is taxable income for that year.
If it chooses to use the net worth method, the government must perform an in-depth financial investigation. Essentially, the investigation and resulting calculation portrays the financial life of an individual, both prior to and during the tax year(s) in question. Because the government is approximating the individual’s income using circumstantial evidence, there are specific requirements in the net worth method of proof to ensure the government’s evidence is adequately dependable to prove beyond a reasonable doubt that the individual had unreported taxable income.
The government proves a prima facie case under the net worth method if it establishes the individual’s opening net worth with reasonable certainty and then shows increases in the net worth each year in question, which adding non-deductible expenditures and excluding known non-taxable receipts for the year, exceed reported taxable income by a substantial amount.
Basic Steps in a Net Worth Method Case
The following are the basic steps necessary in a net worth method case:
- Establish net worth at the end of the taxable year with reasonable certainty.
- Establish net worth at the beginning of the same taxable year, which is then subtracted from the end of year taxable net worth.
- Add non-deductible expenditures.
- Subtract non-taxable receipts from income sources.
- Compare that figure with the amount of taxable income reported by the individual to determine the amount, if any, of underreporting.
Books and Records
The net worth method is frequently used when it would be difficult or impossible to establish an individual’s taxable income by direct evidence. Such as in the case where an individual intentionally fails to keep books and records documenting income and expenses. Or, when an individual’s books and records are inadequate or false. While the books and records are helpful, they are not crucial to the net worth method of proof.
Requirements for Proving Net Worth
In utilizing the net worth method, the government must:
- Determine an opening net worth for the year in question with reasonable certainty,
- Determine an individual’s net worth at the close of the year in question, with any amount over the opening net worth being the net worth increase,
- Determine a likely source of taxable income or refute non-taxable sources of income, and
- Investigate reasonable and timely leads given by the individual as to possible non-taxable sources of income, et cetera.
Opening Net Worth
Net worth increases are established through comparing an individual’s opening net worth against the individual’s net worth at the close of the same year. December 31 of the year just prior to the tax year in question, is the starting point in determining the opening net worth.
For example: If the government is investigating an individual’s tax year 2008, they will utilize the individual’s December 31, 2007 figure for their opening net worth amount for 2008.
In criminal tax cases, an individual’s intent to violate the law is established through circumstantial evidence, usually covering several tax years. Since the basis of the net worth method of proving underreported income is the opening net worth figure, it is essential for the government to establish that figure with reasonable certainty. The government is required to make every effort to determine opening assets and liabilities, while not being held to a mathematical certainty.
After the government has determined the opening net worth with reasonable certainty, it is a detriment to the individual if they do not provide reasonable and timely leads, if any, to dispute the opening net worth figure.
Thorough Investigation
The government must conduct a thorough investigation, with supporting evidence, to meet the threshold of “reasonable certainty” of the opening net worth figure. Often, the government will investigate the financial status of an individual several years prior to the year in question to ensure they are reasonably certain of the opening net worth figure for the specific year in question.
The government’s investigation will include, but not be limited to, subpoenas to financial institutions for records including possible loans, checks of local real estate records for purchase/sale/ownership, checks of local probate records for inheritance, and interviews of witnesses.
Evidence Establishing Opening Net Worth
The opening net worth figure must include all of the individual’s assets that are reasonably determined including assets resulting from non-taxable sources of funds such as gifts, loans, and inheritances, and assets resulting from taxable income. It is important to identify assets acquired in the years prior to the year in question, both for a correct opening net worth figure and as possible basis of funds to acquire assets in the year in question.
For example: If individual received an inheritance of $150,000 in 2007 and the government, in its investigation of the individual’s tax year 2008, failed to discover the $150,000 inheritance received during the prior year, the government’s opening net worth will be understated by $150,000. If the individual utilized the $150,000 inheritance to purchase real property in 2008, the net worth calculation would incorrectly attribute this net worth increase to the individual’s 2008 tax year. The net effect of the government’s error would be to overstate the individual’s taxable income by $150,000 in 2008.
The government will utilize prior income tax returns and financial statements the individual has submitted to the IRS and/or financial institutions as starting points for their opening net worth calculations.
Cash On Hand
The opening cash balance is frequently challenged in net worth cases. Although cash on hand includes currency an individual carries on their person, it also encompasses all cash readily available to the individual that is not deposited in a bank or other financial institution, such as:
- in a safe deposit box,
- in a safe in the home/office, and/or
- hidden in/on the individual’s property.
One defense involving a large opening cash balance is referred to as the cash hoard. In such cases, individuals assert that in years prior to the year in question, they accumulated funds over many/several years through cash gifts from family/friends or an inheritance, et cetera, which they then spent during the year in question.
In disproving the existence of a cash hoard, the government may show the individual’s actions are inconsistent with an individual who had access to large sums of cash, such as:
- taking out high interest loans,
- borrowing nominal amounts from family/friends to pay bills,
- incurring NSF fees for bounced checks,
- buying household items on credit or installment payments, or
- making ATM cash withdrawals in small amounts.
The government will also ask very detailed questions of the individual about a cash hoard, including:
- What was the source(s) of the funds?
- Where were the funds kept?
- Were they always kept in the same location?
- Who else was aware of the funds?
If an asset was acquired with cash during the year in question and cannot be traced to withdrawal from a bank account, then the government must provide evidence to negate a cash hoard.
If an individual reports they received a loan or inheritance from a relative or friend as a basis for unexplained income, the government may review the tax filing history or construct a simple net worth of the family member/friend in their investigation of the accuracy of the individual’s assertion.
Burden of Proof
If the government’s investigation fails to uncover, with reasonable certainty, opening cash on hand amount, the burden then falls to the individual to prove any cash on hand amounts or “cash hoard.” Whether cash on hand, and the amount of such, exists is a matter to ultimately be determined by the jury.
Admissions
The government may rely on statements made by an individual in determining the individual’s opening net worth. Such statements may be made orally to third parties or agents and/or written in the form of financial statements, et cetera. Such statements can be submitted during trial proceedings as admissions by the individual.
The government does not have to corroborate admissions made prior to the offense. Post offense admissions, as a general rule, have to be corroborated. It has been established that the government can corroborate post offense statements by confirmation of the net worth directly or as evidence of an individual’s conduct that supports a tax crime. It has also been established that corroboration of an individual’s cash on hand statement is not necessary, as the validity of any such statement is left to jury determination.
An individual’s tax returns are commonly used in net worth cases in the calculation of an opening net worth figure. Statements made on tax returns of subject years, and tax returns prior to the years in question, can be used as admissions by an individual under Federal Rule of Evidence 801(d)(2)(A).
Information provided on loan applications and financial statements that are provided to financial institutions can be used by the government in determining opening net worth figures and cash on hand amounts. These documents can also be used for impeachment purposes.
In net worth cases, the government can use an individual’s books and records to determine the value of assets, the value of liabilities, prior years’ financial status, refute cash on hand amounts, and business activities during the years in question. The books and records can also be used as admissions.
In the absence of an accountant-client privilege assertion, if an individual directs investigating agents to their accountant/bookkeeper for questions relating to taxes, any statements made by the accountant/bookkeeper is an admission by the individual under Fed. R. Evid. 801(d)(2)(D), whether or not the individual authorized the accountant/bookkeeper to make the statement.
Accountant workpapers, received from the individual and kept in the regular course of business, can be used to determine opening net worth amounts for cash on hand, assets, and liabilities.
Under Title 26, United States Code, Section 7525(2)(A) and (B), accountant-client privileges cannot be asserted in criminal tax matters:
(a) Uniform application to taxpayer communications with federally authorized practitioners
(1) General rule
With respect to tax advice, the same common law protections of confidentiality which apply to a communication between a taxpayer and an attorney shall also apply to a communication between a taxpayer and any federally authorized tax practitioner to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney.
(2) Limitations. Paragraph (1) may only be asserted in-
(A) any noncriminal tax matter before the Internal Revenue Service; and
(B) any noncriminal tax proceeding in Federal court brought by or against the United States.
(3) Definitions. For purposes of this subsection-
(A) Federally authorized tax practitioner
The term “federally authorized tax practitioner” means any individual who is authorized under Federal law to practice before the Internal Revenue Service if such practice is subject to Federal regulation under section 330 of title 31, United States Code.
(B) Tax advice
The term “tax advice” means advice given by an individual with respect to a matter which is within the scope of the individual’s authority to practice described in subparagraph (A) (emphasis supplied).
If the accountant has been retained by the individual’s attorney to assist the attorney in their representation of the individual, under a Kovel agreement, statements by the accountant may fall within the attorney-client privilege.
Statements made by an individual’s attorney may be admissible under Fed. R. Evid. 801(d)(2) as a party-opponent, if the statement is not barred by the attorney-client privilege. Also, an attorney statement is not privileged if it was authorized by the individual. The preparation of a tax return is generally not considered to be covered under the attorney-client privilege.
Source and Application of Funds
An additional technique of determining opening cash on hand is a review of an individual’s available finances in the years just prior to the year(s) in question. This is called a source and application of funds method. Through this method, the government calculates the funds available to the individual in earlier years and the amount the individual spent.
For example: If the defendant received $150,000 available from non-taxable and taxable sources in the years leading up to the year in question, and the individual spent $145,000, there would be only $5,000 cash on hand for the opening net worth calculation.
Net Worth Assets
Generally, when determining an individual’s net worth, assets are reflected at cost, not fair market value. Assets preexisting the year in question are a source of non-taxable funds only to the extent of their basis.
For example: If an individual purchases a home in 2005 for $200,000 and in the year under investigation it increased in value to $350,000, the home is reflected as a net worth asset of $200,000 because the net worth method considers actual costs and expenditures.
There are exceptions to the cost basis rule, as directed by the IRS, those being inheritances (property inherited from a decedent is determined at fair market value at the time of death) and gifts (property attained through gifts and transfers in trust are valued at the amount of the gift given to the individual). If services are paid for in property, then the fair market value of said property is used as an income amount in the net worth calculation.
Across the Board Assets
An asset the individual owned in the opening year and continued to own throughout the years in question, with no decrease or increase in cost, is considered an across the board asset. Because an across the board asset does not change the net worth calculation, the government may choose to leave that asset out of its calculations.
For example: If an individual purchased stock in the amount of $38,000 two years prior to the three years in question, and maintained the stock throughout the three years in question. This would be an across the board asset as the cost basis remained the same.
On occasion, the government will utilize a “-” in their schedule to reflect cash on hand amount that is assumed to remain constant during the year(s) in question.
Bank Accounts/Nominee Accounts
Funds in bank accounts, after reconciliation of outstanding checks and deposited items, are reflected as assets in the net worth calculation. The government will also look for bank accounts an individual may have opened in the name of family or friends.
Assets/Liabilities of Spouse or Children
The assets and liabilities of an individual’s spouse and children will be reviewed to determine if they should be included in the net worth calculation, or whether amounts are de minimus.
Partnership Interest
An individual’s share of the partnership capital is an asset. Absent a partnership agreement allocating percentage of partnership capital, it will be determined each partner has an equal share.
Liabilities
The government must produce evidence of an individual’s liabilities with reasonable certainty. The liabilities are then subtracted from assets to arrive at an individual’s net worth.
Non-Deductible Expenditures
The net worth increase is established after subtracting the ending net worth from the opening net worth. The increase is then adjusted by adding an individual’s non-deductible expenditures for the year in question, including living expenses and other items not reflected as assets.
It is the government’s burden to prove, through independent documentary or testimonial evidence, that expenditures added to the net worth increase are non-deductible expenditures, rather than deductible expenses. Non-deductible expenditures made on behalf of the individual’s spouse or children will be added to the net worth increase.
Examples of non-deductible expenditures that will be added to the net worth increase include:
- food,
- clothing,
- household supplies,
- gifts,
- vacation,
- entertainment, or
- household help.
If the government is not able to establish exact living expenses, the jury can conclude that the individual had necessary living expenses beyond what the government proved.
Reductions in Net Worth
The reason for the net worth calculation is to determine an individual’s taxable income. Therefore, the government must take care to deduct non-taxable items received by the individual in the year in question.
Non-taxable receipts include:
- Gifts,
- Inheritances,
- Tax-exempt interest,
- Life insurance proceeds,
- Non-taxable pensions, or
- Veteran’s benefits.
If an inadvertent computation error is made by the individual or the individual’s accountant, the amount of the error will not be held against the individual in the government’s calculation of net worth.
Attributing Net Worth Increases to Taxable Income
The government will either prove the likely source of the taxable income or negate sources of non-taxable income when establishing net worth increases are the result of currently taxable income.
The government can use direct or circumstantial evidence to support the likely source of taxable income. An individual’s investments in real estate, ownership in a joint venture, ownership of stocks and bonds, and ownership of a business can demonstrate likely sources of unreported taxable income.
The government may introduce evidence of illegal activity to support the likely source taxable income. Such illegal sources include:
- gambling,
- skimming,
- embezzlement, or
- illegal drugs.
Negating Non-Taxable Sources of Funds
The government is not required to go to extreme measures to negate non-taxable income. If it can show that it conducted a thorough investigation and followed reasonable and timely leads provided by the individual, the government has met the requirement of negating non-taxable income from the net worth calculation.
Reasonable Leads
The government must investigate timely leads provided by the individual that are relevant and reasonably able to be checked.
Net Worth Schedules
The government will typically call a witness at the end of their case in chief to summarize the evidence and introduce into evidence schedules/calculations of the individual’s net worth.